The under-performance of value stocks explained

Value investing

Investing in value stocks is not value investing

There is a lot of talk currently about the underperformance of value stocks compared with growth stocks over the last fifteen years. In fact, value investing has performed well against all other styles. This seeming contradiction comes from the fact there is a world of difference between value investing and investing in so called value stocks.

Let’s compare two portfolios. First, that of a value investor. The companies in the value investor’s portfolio will have great prospects for growth. Each stock in this well-balanced diversified portfolio will have been purchased for the long term. Let’s say there are twenty stocks in the portfolio. Only a handful will have been purchased in the last two or three years. Those recent purchases will have been bought at bargain prices; that is, at prices well below intrinsic value. Most of the remaining fifteen or seventeen stocks in the portfolio will be fully priced and some may be priced well over intrinsic value. That is because the prices of those stocks will have gone up since they were purchased. The investor will be in no hurry to sell any of them regardless of how the market prices them in relation to intrinsic value.

Some of the recently purchased stocks may have low price earnings ratios because of temporary negative business news that brought the stock price below fair value in the first place. Some may have higher price earnings ratios because earnings are temporarily depressed. Some will have higher price earnings ratios because the expected future growth of the company justifies a higher ratio. One could not look at the portfolio and say: “Oh that is a value portfolio – I can see those are value stocks”. Yet, every single stock will have been purchased with a margin of safety. The entire portfolio with have been constructed using value investing principles.

Now let’s look at a portfolio made up of ‘value stocks’. As best I understand it, such a portfolio or fund would contain stocks with these characteristics: Stable earnings, strong free cash flow, and a low price in relation to earnings, book value, sales and the intrinsic value of the business. They would have a decent dividend and a history of increasing dividends. But, here’s the problem with this portfolio. The companies’ low ratios may be fully justified by their limited opportunities to reinvest in their businesses and/or limited growth prospects.

Warren Buffett wrote years ago: “Whether appropriate or not, the term ‘value investing [and with time Buffett’s words have been changed to ‘investing in value stocks’] is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a ‘value’ purchase.” (Buffett, 1998)p.85

The term ‘value stock’ can only mislead. It is used by index publishers, mutual funds and ETFs. It is not necessarily consistent with a ‘value’ purchase.

The use of ratios and factors is more difficult than most people think. For example, a superb company can sometimes be bought at a bargain price with a relatively high price earnings ratio. This is not surprising. Earnings can be temporarily depressed by a brief spike in input costs or by a temporary plant shutdown. Statistical analyses of low price earnings ratio stocks will not pick up such situations. Nor will computer based stock screening systems. The most important ingredient in a value purchase is a business analysis of the company rather than a financial analysis. This is a qualitative analysis rather than a quantitative analysis.

The overarching problem is that neither book value nor net earnings are what they used to be. Companies that create intangible assets internally are, with certain limited exceptions, required to expense the related cash outlays. As a result the cost of creating major long-lived corporate assets ends up reducing net or reported earnings while, at the same time, creating long-lived intangible assets that do not appear on the balance sheet. This can have a big impact on price earnings ratios. Screening for low price earnings ratio stocks can exclude companies with substantial spending on intangibles.

On the impact on book value and reported net earnings of corporate investment in intangibles see my post: The fading usefulness of book value

Want to read more about the issues raised in this post take a look at Chapter 25. Investment Styles, and specifically section 25.16 Value Investing and value stocks and section 25.20 Warren Buffett

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